Despite Growth, Apple Has a Problem

Gross margin in its fiscal second quarter is expected to decline. Here's one reason why.

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I've noted here before that customers and suppliers can provide you with a very important window into conditions at your investments. In my case, Micron (MU) is a supplier of memory to Apple (AAPL) and, on last night's conference call, Apple's management had some very interesting things to say.

First, let's understand that Apple is a hot commodity for most suppliers as evidenced by last night's results. iPhone unit sales (36% of revenue) increased 100% year-year and Macintosh unit sales (28% of revenue) jumped 33% from last year. That's the type of growth that has suppliers salivating in the current environment.

However, despite the attractiveness of its growth, Apple is experiencing a fundamental problem as indicated by its guidance. Gross margin in its fiscal second quarter is expected to decline to about 39.0% from last quarter's 40.9%. One of several reasons for the margin decline was explained as higher component costs, specifically DRAM.

The March quarter is historically the weakest quarter of the year for all components in the electronics supply chain. Consequently, pricing of commodities like DRAM, NAND flash, and LCDs usually starts to decline in early December and remains soft until the spring. However, as you can see in the graph below, the current year has been anything but normal from a historical perspective thus far.

DDR3 is the leading-edge DRAM technology and the preferred choice for many applications. However, it's not available in volume from all DRAM suppliers. As a result, what we saw early in the fourth quarter was a shift back to DDR2 in some applications because it was more readily available. But that spike in demand also pushed up prices.

If Apple is faced with rising DRAM prices impacting its gross margin, imagine what it's like for many of the smaller OEMs.

The simple "solution" to this problem would normally be to bring on more capacity. I'm certain that Apple. et al would like nothing better than a return to a buyers market and to see contract prices for memory at half the current levels. But, barring a collapse of demand, that's not happening anytime soon.

When I highlighted Micron last fall, I noted that there's a structural problem that should impede any dramatic increases in DRAM capacity during 2010. That problem is the availability of immersion lithographic scanners -- i.e. the tool that creates the pattern on a silicon wafer. The lead time for the leading-edge technology is nine months or more, assuming your credit is good.

Yesterday's DigiTimes (Taiwan) contained an article suggesting that the problem has surfaced for several of the Taiwanese DRAM companies. Nanya and Inotera (a Nanya-Micron joint venture) were said to be experiencing delays in obtaining their immersion scanners but no specific time-frame was provided. Rexchip (a Powerchip-Elpida joint venture) is expected to be delayed an additional two months due to an immersion tool it had on order.

Essentially all DRAM manufacturers are now in the black or very close to it for the first time in years. But while they may have stopped bleeding, the wounds remain painful and near-death experience (for some) is a vivid memory. All of that will fade at some point as the greed instinct takes over. You'll know when that happens when contract prices run counter-seasonal on the downside.

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